Greek Austerity: Budget Cuts Deepen Recession, Quicken Reckoning

Ever since Greece began teetering toward default last year, European officials have extracted promises of budget cuts in exchange for financial relief. But far from lifting Greece back to fiscal health, according to many economists, austerity appears to making Greece's problems worse, slowing the nation's growth and making it even harder for Athens to repay its bills.

The recession is increasing social unrest and is making it more difficult for Greece to pay off its debts, which in turn has increased the urgent need for European officials to write down Greece's sovereign debt by as much as 60 to 70 percent, some economists said.

"Greece is really in some sort of a depression," said California State University economist Sung Won Sohn. "You cannot solve the problem simply by shrinking the economy indefinitely."

Far more than the lives and aspirations of the Greeks hang in the balance. The effects of a Greek default would be felt across Europe, hitting major lenders with losses just as many banks are grappling with inadequate reserves of capital and pulling back on loans, depriving many national economies of fuel for growth. It would drag on the global economy, dampening exports from the United States to Europe and potentially Asia.

In short, the austerity that has been prescribed for Greece seems not only to be failing to fix the country, but now runs the risk of reinforcing an economic slowdown around the much of the globe.

In response to budget cuts, the Greek unemployment rate has spiked to 16.5 percent, and Greece's deficit has grown 15 percent as a deeper-than-expected recession has swallowed potential tax revenues as Greeks have been laid off or are making less money.

It has become increasingly clear that Greece will not be able to pay its debts, even with the 21 percent writedown agreed upon in July. As a result, European leaders have been debating how much they should ask banks to write down Greek debt. Major European banks reportedly have protested against a proposal for them to write down up to 60 percent of Greece's debt, arguing for a 40 percent writedown instead, according to Bloomberg News.

Banks in France, Greece, Belgium and Germany are the most exposed to Greek sovereign debt, according to the Guardian. The fear is that, if Greece suddenly defaults on its debt, investors will demand their deposits from major European banks all at once. Since many of these banks are undercapitalized, they could run out of cash and declare bankruptcy -- prompting investors to cash their deposits at other banks at the same time, causing borrowing rates to spike and spurring more bank bankruptcies and European government defaults.

A financial crisis and recession in Europe would be likely to drag down the global economy, since Europe accounts for about one-fifth of global economic output. In the United States, exports to Europe would slow, banks would lend less, consumers would spend less and businesses would postpone hiring, according to some economists. China's export-driven economy would slow similarly, reverberating to the U.S. and around the world.

"Exports have been a major source of what little strength [the United States has] in the economy, and Europe is in no shape to import much from other countries," Sohn said.

In response to severe budget cuts, Greece is entering a "negative feedback loop" in which it is forced to slash spending to receive new loans, but the resulting economic slowdown widens the deficit, forcing Greece to make even more budget cuts that worsen the economy even more, said Benjamin Reitzes, senior economist at BMO Capital Markets.

The Greek recession has made it all the more urgent for Europe to accept the inevitable and restructure Greece's debt, said former Obama administration economic adviser Jared Bernstein.

European leaders prescribed austerity for Greece with faulty economic logic. The European Central Bank dismissed warnings that budget cuts would slow down the Greek economy and worsen the deficit in a July 2010 report. The ECB wrote in the report that spending cuts aimed at reducing the debt were "the most likely" to promote long-term economic growth. The report also maintained that deep spending cuts would reassure investors and lower interest rates.

On the contrary, interest rates on Greek debt have spiked as investors have fled from Greek debt, expecting a large writedown or default.

The deep recession has worsened Greece's fiscal and economic outlook. The social unrest kindled by high youth unemployment now has made it more likely for the current Greek administration to fall, which would make it more likely for the Greek government to suddenly default, said Diego Iscaro, senior European economist at IHS Global Insight.

Many European countries are trying to cut their budgets at once, depleting demand across the continent, Iscaro said.

Budget cuts are least damaging to the economy when coupled with a decrease in the value of the currency, making goods cheaper around the world and encouraging export sales, said Harvard economist Richard Cooper. But since Greece is chained to the euro -- which the ECB refuses to cheapen since it is mandated to protect against inflation -- Greece is suffering through a deep recession that is adding to pressure for Greece to leave the euro altogether, said Brookings Institution economist Gary Burtless.

Some economists said that Greece first needs to raise revenue from its many tax evaders before slashing spending. Those measures, they said, would have a less severe impact on the economy and shrink the deficit to a more meaningful extent. Greece loses as much as $30 billion per year to tax evasion.

Since the economy has shrunk and tax evasion is so rampant, many Greeks who do pay taxes are unlikely to comply with tax hikes, said NYU economist Nicholas Economides. He said that a long-term solution to Greece's debt must include a more effective tax collection system and sustained economic growth.

"Without new development, without new jobs, without growth, the Greek economy will keep going down," Economides said. "To collect more money, you need to get out of the recession."

He said that the European Union and International Monetary Fund should direct $10 to $20 billion to Greece for an economic stimulus, by investing in renewable energy production, tourism and Internet use in Greece.